A Trigger to Restore Payroll Tax?

By Alicia H. Munnell

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Alicia Munnell, the director of the Center for Retirement Research at Boston College, is a weekly contributor to “Encore.”

Where is gridlock when we need it? Republicans and Democrats both support extending the payroll tax cut that is due to expire at the end of the year, though they have yet to agree on the details. Fortunately, the likely compromise only extends the cut in the employee tax rate from 6.2% to 4.2% on earnings up to the Social Security maximum ($106,800) that became effective in January 2011. If so, it would not incorporate the president’s proposals to further reduce the employees’ rate to 3.1% and to similarly cut the employers’ rate to 3.1% to the extent they take on new workers. Since the two political parties appear to be so agreeable, could they agree on one more thing – a trigger mechanism that would reinstate the payroll tax rate as the economy recovers? That is, half the cut could be restored once the unemployment rate hit 7.5% and the other half once it hit 5.5%.

The tradeoff here is between the short-term impact on the economy and the long-term impact on the Social Security program. Mark Zandi, chief economist at Moody’s Analytics estimates that not extending the cut could subtract 0.7percentage points from the economic growth rate. No one seriously argues that the cut in the employees’ rate is a job creator, but taking money out of the paychecks of millions of working Americans could indeed have a negative effect. But the compromise involves offsetting the cost of the payroll tax cut with reduced spending and/or increased taxes elsewhere in the budget, so it is unclear just how stimulative the total package will be.

On the other hand, the risk to the Social Security program is clear. Before the 2011 cut, the Social Security financing story was one where the average cost rate for the next 75 years was 16.2% and the scheduled income rate was 14.0%, producing a deficit of 2.2%. That figure means that if the payroll tax were raised immediately by 2.2 percentage points – 1.1% each for the employer and employee – the government would be able to pay the current package of benefits for everyone who reaches retirement age through 2085.

A 2-percentage-point cut in the employee payroll tax changes the story. The deficit becomes 4.2% of payrolls. Yes, general revenues are being credited to the trust funds to make up for foregone revenues in the short run, but restoring balance to Social Security, which in 2010 looked trivial, now appears daunting. The expiration of any reduction in a tax is now characterized as a tax increase, and the resistance to tax increases is ferocious. Policymakers will have put themselves in a position where a balancing of tax increases and benefit cuts will simply involve restoring the cut. Benefit cuts will be much larger than they would have been before people started fooling around with the payroll tax.

The only way to avoid such a situation is to have the payroll tax cut be restored automatically. That is, Congress should link the extension of the cut to a trigger. In that way, as the economy recovers, Social Security will see its revenue source restored. And solving Social Security’s long-run financing gap will once again become a trivial exercise.

Comments (3 of 3)

When people retiring today started working, the total “payroll tax” was about half of today’s rate. It ranged between 7 to 8% in the mid-1960′s and only applied to about $45,000 of income (when adjusted for inflation to today’s dollars). Today it taxes 15.3% of the first $110,000 and 2.9% of everything beyond that. (Rates include both employee + employer sides, as most economists say that the employee pays both through reduced pay.)

This expanded tax is unfair to today’s entering workers, many of whom already have high student loan debt just to get jobs with minimal pay that used to require no degree. There should be a permanent payroll tax cut to put the rate back at the 7 to 8% total that the previous generation enjoyed. To pay for this cut, the retirement age could be raised to match today’s longer life expectancies and restore the average number of years on social security to what it was then. That would give today’s generation of young people the same opportunities their parents had to build savings.

A permanent tax cut would also help the economy. The current total of income and payroll taxes results in high marginal tax rates for even relatively modest incomes. A self-employed person making $20,000 per year is at a marginal rate of approximately 30%. (15.3% payroll tax + 15% income tax). A similar person earning $45,000 is at a marginal rate of almost 40% (15.3% + 25%). When combined with phaseouts of other tax incentives or federal benefits, the implicit income tax rate can be quite high, thus reducing the monetary incentive to increase pay through jobs with more responsibility, increased personal liability, increased hours, or increased commutes.

Very deceptive, seems to me. Part of the deception is that the payroll ‘tax’ is not a tax, but an insurance premium.

Undermining SS with ‘payroll tax’ cut seems crazy (and deceitful, especially on the part of Democrats). If they really wanted to help the economy, the 99%, and preserve SS, then they’d just do a lower/middle level income tax bracket decrease.

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About Encore

Encore examines the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities and priorities of today’s retirees. The blog also explores news that affects retirement, from the Wall Street Journal Digital Network and around the web. Lead bloggers are reporter Catey Hill and senior editor Jeremy Olshan. Other contributors include The Wall Street Journal’s retirement columnists Glenn Ruffenach and Anne Tergesen; the Director for the Center for Retirement Research at Boston College, Alicia Munnell; and the Director of Research for Pinnacle Advisory Group, Michael Kitces, CFP.